Deutsche in Danger?

Deutsche Bank has been slapped with a $14 billion fine over a charge it mis-sold US mortgage securities. The case has raised worrying questions about the stability of the global financial giant.

By Venture staff

Deutsche Bank is one of the most dominant financial institutions in the world and Europe’s largest investment bank with total assets exceeding 1.8 trillion euros and over 100,000 employees. Similar to many of its peers, the bank has faced a number of lawsuits since 2012 that has hit more than 12 billion euros. However, its most recent litigation is its biggest yet, and might become one of the biggest risks to our financial system.

Germany’s largest lender is among the top 10 investment banks globally in terms of securitization, holding a 6.4 percent share of the US residential mortgage-backed securities market, according to rating agency Moody’s. Following the financial crisis, tougher regulations made it more expensive for banks to trade with complex securities with less capital. Deutsche had to not only respond to this, but also to tougher market conditions. Banks are required to hold more than a fifth of the value of such securities as capital to create a cushion against losses, making it more expensive than many other forms of banking. As a result, this has prompted banks to shift from trading loans to helping clients create securities as a way of raising finance.

In September 2016, the US Department of Justice demanded Deutsche pay up to $14 billion to settle claims it misled investors when selling mortgage-backed securities before the crisis. This came as a shock to the bank, which had only expected to cough up a mere $6 billion.

This litigation rose from the Libor scandal of 2015. Libor is the rate banks charge each other for short-term loans and is tied to trillions of dollars in securities and loans. According to the Department of Justice, for a period of 11 years, Deutsche Bank employees mis-sold subprime loans with artificially inflated rates to help boost the value of the bank’s trading books. This was carried out to hide $12 billion in losses to avoid a government bailout following the crisis. It’s alleged there was also additional manipulation of foreign exchange rates, and gold and silver prices.

As a result of the litigation, Deutsche Bank shares, which have lost around half of their value this year and have reached a 30-decade low, fell by almost a quarter in the two weeks following the fine demand, dragging down many of its peers. Analysts say the bank may need to raise fresh funds from investors or sell assets to shore up its capital ratios. As we have seen in the past, this could lead to domino effect amongst global banks; when one goes down, others can follow.

The demand from the Department of Justice was recently rejected by Deutsche Bank. Analysts believe that the market uncertainties over the fine has exposed much deeper structural weaknesses that could continue to taint Europe’s economy and banking systems with negative interest rates, weak economic growth, and the tightening of regulations.

The $14 billion settlement demand is one of the largest of recent years. Comparatively, US investment bank Goldman Sachs, which had a slightly larger share of the US mortgage-backed securities market than Deutsche, reached a settlement of $5 billion over similar allegations, and paid it off earlier this year. In 2014, the Department of Justice asked Citigroup to pay $12 billion to resolve an investigation into the sale of shoddy mortgage-backed securities. The fine eventually came in at $7 billion.

It is not unusual for the Department of Justice to begin settlement negotiations with an amount higher than the ultimate penalty. With strict negotiations (involving tedious restructuring of the financial institution), both sides might reach an agreement for a lower fee.

Deutsche’s problems alarmed political leaders in Germany, which is the EU’s largest economy and the home to the European Central Bank. German Finance Minister Wolfgang Schaeuble took the unusual step of voicing public support for Deutsche, and a senior opposition figure said he expected the government to step in as a last resort if needed.

With Deutsche rejecting the $14 billion fine, a final agreement was reached on 23rd December, 2016 for Deutsche to make a fine total payment of $7.2 bn that will be made up of a civil penalty of $3.1bn, as well as $4.1bn in consumer relief. Because the bank did not set aside enough provisioning to cover the litigation, Deutsche has been looking for ways to reach a satisfactory scenario that would not exacerbate the European, and world, economy. Recently, the bank was looking to cut its loan securitization business, starting with repackaged US mortgages. Securitization cutbacks could become an essential part of an expected strategic overhaul at the bank. As well as rolling back the repackaging and resale of US mortgages, European car loan securitization and other areas may also be cut.

Deutsche has set aside $5.72 billion in provisions against litigations. Nonetheless, and due to high uncertainty with the future of the bank, the following scenarios could underline the extent of the bank’s survival to be able to make the $7.2 billion settlement:

With the recent approval of completing the sale of its $4 billion minority stake in China’s Huaxia Bank, the bank could add to the provisioning if it could put a stop to speculations about its weak capital position. This should trigger a rebound in its share price and shore up client confidence in its financial position by the time the bank reaches its year-end 2016 financial results.

To do this, Deutsche would need to raise capital through a rights issue. Given that the share price more than halved in the past year to a level 70 percent below its book value, an equity issue would be unreasonably dilutive to its common equity tier one ratio—the key measure of balance sheet strength. The ratio stood at 10.8 percent in June 2016, well below most rivals and its own target of 12.5 percent. However, every $1 billion of extra provisions would erode its common equity tier one ratio by 0.25 percentage points. Analysts at JP Morgan estimated that a rights issue at a 25 percent discount could raise as much as 5.6 billion euros, adding less than 1.4 percentage points to its common equity tier one ratio, which is obviously not enough to reach the target of such a large fine.

Another option the bank would have to consider is the selling assets. One such asset could be the sale of Postbank, the former post office bank that Deutsche acquired in 2010. Nevertheless, it might be difficult to find a buyer due to a lack of buyers and poor market conditions.

Deutsche could benefit from a supply of cheap funding from the European Central Bank to help it recover while it works on its disposals. It has been rumored that hedge funds have pushed for a sale of its asset management division, which is estimated to be worth $8 billion.

Some hedge funds have been reducing their exposure to the bank by pulling collateral for derivatives trades from Deutsche, raising fears of a run on the bank. Given that a settlement was reached with the Department of Justice, clients are unlikely to do so. Nonetheless, with other cases piling up at the bank (such as a market manipulation case of $5 billion at Deutche’s Russian branch), this could result in a rating agency downgrade, forcing more clients to jump. To reduce this possibility, the bank will need to wipe out its most junior debt and convert other unsecured loans into equity to help rebuild its balance sheet over the medium-term.

In the worst-case scenario, the German government could step in and take a 25 percent stake in the bank if faced with a loss of client confidence. This would allow states to inject money into it once losses on creditors reach 8 percent of liabilities. In Deutsche Bank’s case, this is equal to 139 billion euros of bondholder losses, which could be detrimental to the financial system.

Another worst-case scenario is for the government to merge Deutsche Bank with Commerzbank, in which it already has a minority stake. While this will remain an unpopular decision given the settlement of the case, it may allow the government to provide support to Deutsche without it being considered state aid should Deutsche’s cases result in a larger sum of fines.

Despite all such measures, the case of Deutsche Bank boils down to tackling the simplest problems to help settle its financial uncertainty. Among such measures is the bank’s five-year plan known as Strategy 2020, where its priorities include cost cutting, deleveraging, and simplifying its operations. Since the Department of Justice litigation, the bank has revised its strategy to include credit-positive measures that would help it achieve a more efficient and less leveraged business model. This includes: raising its provisions for all outstanding legal cases to 5.9 billion euros (from 5.5 billion euros), the de-risking and re-positioning of the bank, the disposal of Postbank, 3.8 billion euros of gross cost cuts, and the cancellation of equity dividends for 2015 and 2016.

Although the strategy is likely to help the bank pay the full $7.2 billion fee, the piling of other cases might not. Nonetheless, the strategy is expected to help mediate the underlying situation and show productive results from 2018 onwards. We will now have to wait and see if if Deutsche’s management will follow its promises of a better banking operation.